The
basic question regarding sovereign debt is why sovereign borrowers ever
repay, provided that creditors have no power to foreclose on any of their
assets. In this paper we suggest an answer: sovereign debt will be served
as long as the median voter is a net loser from default. Default generates
a reallocation of wealth from locals to foreigners, but also from
local debtholders to local tax payers. Sovereign debt is stable as long
as the median voter’s interests are more aligned with the foreign lenders
than with the local taxpayers. We further augment the model with
elements of market microstructure theory to address the question how
markets rationally use capital flows so as to infer the stability of debt
structure. We show that foreign demand shocks can destabilise debt
even though they are not fundamental. We also show that more volatile
foreign demand reduces a country’s debt capacity. Our work thus
integrates elements of market microstructure theory into politicaleconomy modeling.